In the last post I identified the personal savings rate as the most important measurement in personal finance (What is the Most Important Measurement in Personal Finance?) In this post I will teach you how to calculate your personal savings rate and how to interpret the results.
Americans are notoriously poor savers. The United States has among the lowest savings rates in the developed world, and the long-term trend is getting worse, not better. Daniel Solin, in his book The Smartest Money book You’ll Ever Read, reports that the savings rate in the US declined steadily over the past five decades from 9.9% in the 1960s to 2.3% in the 2000s. While the savings rate has rebounded slightly since 2010 – it was estimated at 4.4% for July 2013 – it is still far less than it needs to be for individuals to be prepared for financial emergencies and retirement. How does your personal savings rate compare to the miserable national average? How can you calculate this?
Calculating Your Personal Savings Rate
The personal savings rate is the ratio of personal savings to total income less taxes. To calculate your personal savings rate follow these steps:
Step One: Calculate your personal savings; include the following:
- Personal contributions to retirement accounts
- Employer contributions to retirement accounts
- Other contributions to saving or investment accounts
- Amount of debt paid off (only include the portion of your payments that decrease the balance of your debt, not the portion that goes to interest)
- Subtract any new debt incurred
Step Two: Calculate your total income less taxes
- Subtract taxes from your gross pay
- Add any other income
- Add employer contributions to your retirement (this is income to you, but does not show up as income on your paystub or W-2)
Step Three: Divide your personal savings by income less taxes and multiply the result by 100 to change the decimal to a percentage.
One of the reasons the personal savings rate is the most important measurement in personal finance is that it reflects the progress you are making financially whether you are saving money or paying off debt. A dollar used for either purpose improves your financial situation by the same amount, and this is reflected in your personal savings rate.
What Does it Mean?
Now that you have calculated your personal savings rate, what does it mean? What is a good score? Hopefully you are at least saving more than the national average, but that is a pretty low bar to set. What you should be saving is subjective, and different for people in different circumstances, but as a general rule you need to have a personal savings rate of at least 10% over the long term to establish financial stability, and at least 20% to make progress towards financial independence.
How Often Should You Measure Your Personal Savings Rate?
You should measure your personal savings rate at least once per year. If you are happy with the result that is probably sufficient, but if your savings rate is below where you want it to be you should measure it more often – either quarterly or monthly. When you are struggling in an area you need to increase the frequency of the feedback measuring that area. Of course, this goes against human nature and takes a lot of courage to do. When you are struggling it is much easier to ignore the problem than confront it with the facts, but facts are exactly what you need.
Charles C. Coonradt summed up the importance of keeping score financially in his book The Game of Work when he stated:
It is a fact of life that those who keep score, whether they are winning or losing, win more over the long run…They would rather know the score while losing than not know the score. The people who achieve financial independence do so by knowing the score. They are the people who set specific goals and track the progress towards these goals, even when things are not going smoothly. I have never met a winner who didn’t know the score.
Keeping score is an extremely important concept in personal finance and your personal savings rate is a vital score to know. Start now by calculating your personal savings rate, setting a goal on what you want it to be, devising a plan to get there, and tracking your progress over time. If you have calculated your personal savings rate I would be curious to know what you came up with. Are you above or below the national average? Over the next several posts we will discuss ways to increase your personal savings rate.